Investment professionals are taught that pension savers face four main risks: the risk that they have less to retire on than they expect or need (shortfall risk), the risk of capital loss (capital risk), the risk of their investments not keeping pace with interest rates (interest risk) or of being eroded by inflation (inflation risk).
There are a variety of other risks - lifestyle changes, mortality improvements, regulatory or tax revisions – which may also impact on the main high-level risks. But often, rather than exploring these risks in detail and at length, all risks are simplified into a single assessment called ‘appetite for risk’ (normally on a 1 to 5 or low to high scale) expressed over a period of time.
This is understandable because clients often have no idea what investment risks are and advisers do not have the time or tools to properly explain it to them. As a result, clients work their way into simple risk categories that best approximate their status.
When it comes to corporate pensions, the issue is no better understood. An individual member of a money purchase or defined contribution scheme often has little guidance when self-assessing or being assessed on investment risk – which is again interpreted as a single risk factor rather than multiple factors. The same is true of a corporate defined benefit pension trust client, where an additional unique risk – funding risk – exists. It tends to be only trustees of the largest, multi-billion pound schemes where the concept of risk is explored in depth. So how could risk instead be approached?
Like almost everything in financial services from bond yields to hedge fund strategies, what seems complex at the outset rarely is when broken down into its component parts. With risk,the first point to explain is that, while investing involves risk, not investing does as well. There are a variety of risks that we all undertake and accept, willingly and consciously or not. Accepting that we cannot avoid all risks, the question is: which do we concern ourselves with most? For a member of a money purchase pension scheme, the chief risks are the shortfall risk and the capital risk.
Given a time horizon of 20 years, which risk is more important? This is the key question that the client must decide, but logically you might expect shortfall to matter much more than capital risk.
What determines the outcome of any capital risk? Investment returns, inflation, contributions, personal health and future market interest rates (i.e. gilt yields). By making sensible assumptions about the risks that the client has no control over – market rates and health – the client is in a position to make a decision about the balance between investment returns, contribution rates and capital risk. They may choose to maximise investment returns and capital risk in return for lower contribution rates. By doing so they exchange high capital risk for low shortfall risk, and, if they cannot afford higher contributions, this may well be the right strategy for them.
But would advisers feel safe recommending such an approach if there is no back-up plan? Perhaps not, but this should be the client’s choice. The adviser’s task is to help them come to their own conclusion about the various risks they face, document the outcome and come up with an investment plan to fit it. All too often clients end up with so-called medium-level risk assessments simply because that is the easiest and safest course, even though it may expose a client to the main risk they face: retirement income shortfall.
So how should risk be quantified? Simple spreadsheet models can help clients juggle the balance of theoretical outcomes, contrasting different return and contribution rates. When it comes to capital risk, volatility expressed as annualised standard deviation of returns is the most popular; others, such as value at risk (VaR) can be used. But care must be taken. The usefulness of these numbers is in their relative
indications; on their own they can be unhelpful. Knowing, for instance, that the annualised volatility of investment X is 12 per cent and that, therefore, in 95 per cent of historical instances the annual return has been between +24 per cent and -24 per cent of its average, is not particularly helpful. Knowing that investment Y is half as risky as investment X, because its price fluctuates less frequently so that the range of likely outcomes is narrower (plus or minus 12 per cent of its mean instead of plus or minus 24 per cent) is more helpful when properly explained.
Quantifying the risk of capital loss can be useful in sanity checking whether the client can really stomach the strategy implied by their desired balance between contributions and investment returns. They might think they are comfortable with a high level of risk in principle over a long period, but what would happen if they really did lose 20 per cent in one year? How regularly should a strategy be reset and recalibrated as the time horizon naturally shortens?
When it comes to defined benefit pension schemes, the main risks are slightly different:
– A: The scheme is underfunded when the employer becomes insolvent, and so is taken over by the Pension Protection Fund causing a partial loss of benefits
- B: The funding position deteriorates between three-yearly regulatory valuations, causing the company to increase contributions
- C: The scheme fails to become fully funded over the agreed time period
As ever, there are many other risks, but, sticking to the main headline issues above, it is evident that there are competing interests. The trustees of the scheme, which would include staff members, are most worried about A. The employer is most worried about B. Most schemes of this type are underfunded and have, typically, a 10-year plan to become fully funded. In this case tackling risk C – the risk of being underfunded after 10 years – lies the Pension Regulator’s main concern.
But unless the employer has extremely deep pockets, the trustees will worry that scenario A – insolvency – could happen at any time, leaving the trustees out on a limb. The company wants to maximise investment growth so the scheme can meet its target of being fully funded while minimising company contributions. But could all parties cope with the risk of losing 20 per cent of scheme assets in one year? The company may be happy to take this risk, but the trustees could be less inclined. A fine balance between various risks needs to found, but this time with two or three groups instead of one person.
To complicate matters further, there is more than one time horizon at play. If the company is single-mindedly concerned about minimising the risk of funding levels deteriorating before the next valuation in three years’ time, then its overwhelming priority is risk B – funding risk; the risk of the scheme’s liabilities growing faster than its investments in the short term. In this instance, the preference may be to adopt a liability-based investment approach. This style places short-term funding risk as the top priority, pushing longer-term shortfall risk and immediate capital risk down the order respectively.
Pension planning is all about managing risk and striking the right investment plan is about prioritising all the risks that investors face in the order that matters to them. If investment planning starts with this prioritising, strategies better attuned to clients should follow.
